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Gladstone Capital: A BDC With a Twist

This highly respected BDC turns in solid results, and is investor-friendly, to boot.

GladstoneCapital(NASDAQ:GLAD) is quite the investor-friendly business-development company. It has the neat twist of paying a monthly dividend. While that's indeed a nice touch, investors should focus on the lackluster business results and the valuation, which is disturbingly high when compared to high quality BDCs like American Capital(NASDAQ:ACAS) and Allied Capital(NYSE:ALD).

For the 2006 fiscal year, total investment income increased nearly 12% to 26.9 million, while the dividend grew 8% to $1.64 a share. Net asset value increased as well, but only about 5% for the year to $14.02 per share. While the results were respectable when compared to peers, the company trades at 1.7 times NAV -- a very high ratio when higher quality names trade at lower levels.

Another shareholder-friendly measure worth paying attention to is the company's loan-grading system. Gladstone's system is a little more detailed than the typical 1 to 4 rating employed by most BDCs. The company breaks things down in a 1-to-10 system, with 10 being the highest (best), and 1 being the lowest rating -- and the highest risk of default and capital loss. Currently, Gladstone rates its overall portfolio a weighted average of 6.9, down from a weighted average of 7.2 in the first quarter. Not a huge move, but one worth keeping an eye on if it continues to worsen.

A key consideration for shareholders when investigating BDCs is whether the company is managed by external management or internal management. Externally managed BDCs like Gladstone, Ares Capital, and Apollo Investment are advised by management teams from a separate entity -- in most cases, a private equity firm. Operating expenses tend to run higher for these players, as management typically works under "2 and 20" compensation schemes similar to hedge funds, where the fees are 2% of assets under management and 20% of any realized gains.

Indeed, that's essentially what Gladstone adopted as its new fee plan going forward, with some additional incentives once the net investment income for the quarter exceeds the hurdle rate, which is 1.75% of assets under management in any given quarter. Previously, Gladstone management had been compensated on a straight 2% of assets under management. Internally managed BDCs like American Capital and Allied Capital tend to have lower fees because of the lack of an external advisor. Case in point -- American Capital's salaries, benefits, and stock options compensation ran about 1.6% of assets in 2005.

Not quite the compensation levels of investment banks like Goldman Sachs(NYSE:GS), Merrill Lynch(NYSE:MER), or Morgan Stanley(NYSE:MS), but I suspect these BDC guys will tell you it's all about the thrill of doing a challenging deal.